How to reduce risk in an investment portfolio

Often, It is only when we see a big drop in the stock market do we recognise the need to worry about risk and how to manage it. What if a market crash wipes all the returns I have got so far? What if there is not enough time to recover before I need to withdraw for my goal? These are some practical questions and I would like to consider practical answers for these in a series of posts, starting with this one: How do I reduce risk in an investment portfolio – part 1: the basics.

This would be my own version of “big data”. So from just on the sequence we can scale up to 1000s of return sequences and back-test the efficiency of different portfolio management strategies. I shall explain how exactly this is created in the second part. In this post, which is part of re-assemble – a series on the basics of money management, we will consider some examples.

I am surprised at how many people have blind faith in equity. Even if they get sustained poor returns, many are confident that things will turn around just before the need the money. This is atrociously stupid. Please recognise that the money in the stock market is of no use! It is real money only when you withdraw!

Let us consider a goal that is 15 years away. The current cost of that goal is 10 lakh. Assuming 10% yearly inflation, the future cost is shown below (blue dots). If we start investing for this in a mix of equity and debt (fixed income), the corpus assuming same returns (10% from equity and 7% from debt – both post-tax), the total corpus will be shown as below. The investment is assumed to increase 5% each year.

Naturally, the aim should be for corpus (red line) to hit the target (blue line) on or before the end of the 15Y period. We start from 0, so it ends at 14. When the returns are fixed, you get a nice smooth corpus growth. Returns in real life fluctuate wildly as you will see below. This is known as sequence of returns.

Now, there are two way to invest in equity and debt. Use the same asset allocation for each year. Say 60% equity and 40% debt. We will refer to this as constant equity allocation

Or we can reduce equity gradually as we approach the goal. I prefer a step-wise decrease (on paper at least) and this is the approach recommended in the Freefincal Robo Advisory Software Template. We will refer to this as the reducing equity allocation.

Portfolio Risk reduction for Return sequence 1 (RS1)

Assuming a 7% fixed return from debt year-on year, this is a real Sensex return sequence from the past:

-18%, -12%, 27%, -27%, 52%, -13%, -22%, -3%, 69%, 23%, 43%, 54%, 35%, -55%, 86%. Each of these is a return after one of year of investing. So 15 annual returns for 15 years of investing.

RS1: Constant Equity method

The blue dots represent the increase in targe corpus due to inflation. The red dots show the growth of the actual corpus. No rebalancing is done. That is, although we will invest 60% of a sum in equity and 40% in debt, we will not worry about the asset allocation of the corpus.Notice how dangerous the constant equity approach is.

If I decrease the investment to equity but do not do anything to the value of the equity portfolio, that is I do not rebalance, then there is really no benefit.

However, I also rebalance as per the reducing equity schedule as shown above, we get a nice smooth approach to the target corpus well before the target date.

What is the message here? (1) Employ a reducing equity schedule and religiously stick to it. This is a simple way to reduce the sequence of returns risk. (2) Do not get married with a SIP. Invest manually on your own. It will take 30 seconds of your time. This will get you into portfolio management mode. You can invest or less each month as per the set schedule or change mid-way.

Hang on, we just tried on return sequence. Let us try some more. In the second part of this post, I will post the results of tens of hundreds of sequences. The following graphs are for food for thought. Please note that in the decreasing equity method, the unrebalanced graph is not of much use. So focus on the green dots alone.

Portfolio Risk reduction for Return sequence 5 (RS5)

Portfolio Risk reduction for Return sequence 6 (RS6)

0%; -5%; 75%; -26%; -19%; -8%; 72%; 17%; 54%; 21%; 30%; -49%

106%; 6%; -3%

RS6: Constant Equity method

RS6: Decreasing Equity method

Impressions

For the six different Sensex return sequences considered, the decreasing equity method + annual rebalancing works even if the return after the first 5-6 years is negative! This means, you need to take the decreasing equity contribution into the investment amount calculation from day one. The robo advisory template does this for you. The question is, are there any sequence of returns in the past where it has failed? We will consider that in the second part.

Over the course of this summer, I will gradually expand this analysis to early retirement portfolio as well.

Re-Assemble: money management basics for young earners

Re-assemble is a series focussing on the basics of money management for young earners.

Do check out these related articles:

About the AuthorM. Pattabiraman(PhD) is the author and owner of freefincal.com. He is an associate professor at the Indian Institute of Technology, Madras since Aug 2006. Follow @freefincal “Pattu” as he is popularly known, has co-authored two print-books, You can be rich too with goal based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
Pattu publishes unbiased, promotion-free research, analysis and holistic money management advice. Freefincal serves more than one million readers a year (2.5 million page views) with numbers based analysis on topical issues and has more than a 100 free calculators on different aspects of insurance and investment analysis.
He conducts free money management sessions for corporates and associations(see details below). Previous engagements include World Bank, RBI, BHEL, Asian Paints, TamilNadu Investors Association etc. Contact information: freefincal {at} Gmail {dot} com (sponsored posts or paid collaborations will not be entertained)

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3 Comments

Pattu Sir,I have purchased your book You can be rich too.It helped me greatly to invest in mutual funds.I read all of your articles.To day’s article is also very interesting and informative. There is one more risk.Only you can tell what steps one should take to protect investment in mutual funds.In these days of high tech world ,it has become risky to keep your life long savings in banka/c.Any tech savvy criminal can withdraw all the money from your bank savings account before you wake up.Same fear strikes you when you invest your hard saved money in mutual funds and some body withdraws all the money in one go and law is unable to catch the culprit.You can well analyse all the factors and guide your readers about protecting your investment in mutual funds.

I am currently investing in an ELSS scheme for the last 3 years through SIP mode. Also i am investing lump sum amount of around 6000-7000 in the same scheme and folio every 3-4 months. I want to know if the compounding formula will be calculated together for SIP and lump sum or it will calculated separately.( SIP amount compound interest calculated separately and lump sum amount compound interest calculated separately).